LONDON (ICIS)--AkzoNobel has adopted a strategy of margin growth and internal realignment over expanding volumes as the Netherlands-based paints and coatings producer looks to significantly increase its profitability over the next two years, according to CEO Thierry Vanlancker.CEO Thierry Vanlancker. Source: AkzoNobel.
The company allowed volumes to fall year on year for every quarter of 2018 for its three key divisions – decorative paints, performance coatings and paints and coatings- while gradually improving price/mix.
The move away from market share growth was largely dictated by vertiginous increases in raw materials pricing over the last two years, which added €750m to AkzoNobel’s operating costs in 2017-18 and made the calculus on lower-margin product much more brutal.
Price movements for paints feedstock titanium dioxide (TiO2)
The company is currently seeking to increase its return on sales (RoS) excluding unallocated costs sharply from the 10.6% recorded in the second half of 2018 to 15% by 2020, and this focus on profitability has intensified focus on how AkzoNobel should operate as a business.
“At one point the 15 by 20 [initiative] position was we have to grow ourselves into prosperity and I think it is clear that that would not have been a good path,” Vanlancker said. “We basically decided to look at how we get our own house in order versus growing ourselves to something.”
The strategy appeared to pay off in the fourth quarter of 2018, with AkzoNobel the only paints and coatings producer to not underperform market expectations or issue a profit warning.
US-based PPG – which spent a significant portion of 2017 trying to buy AkzoNobel – issued a profit warning ahead of its fourth-quarter results, citing raw materials costs and weak China demand, while Sherwin-Williams blamed bearish North American retail traffic for “disappointing” performance.
AkzoNobel’s fourth-quarter adjusted operating income stood at €181m compared to €178m during the same period a year earlier, excluding the €5.8bn booked from the sale of its specialty chemicals division in October 2018.
Improved pricing added €196m to fourth-quarter operating income, offsetting the €121m year on year increase in raw materials costs during the same period.
AkzoNobel price and volume adjustments 2017-18
Industrial and powder coatings were bright spots during the quarter, as was demand in Europe, Asia and Latin America, but foreign exchange issues as well as overheating raw material costs continued to dog the company, particularly on the back of significant inflation in Venezuela, Brazil and Turkey.
The marine coatings sector, which has been a laggard for the company for several years, stabilised during the quarter.
COST INCREASES AND VOLUME
The extent of cost increases made using volumes to drive profits a difficult strategy, Vanlancker said.
“I think the difference might have been that other players in the market may have felt in the beginning ’hey, Akzo has stepped away from volume, great opportunity for us'… [but] some have in our view been relatively late to step up for pricing initiatives,” he said.
“If you do the calculations, at one point there was simply not enough volume available to make up for what gets shaved off,” he added.
Cost hikes have led the company to step back from some markets previously perceived as growth targets.
“At the end of 2016-17 the decision was really to go for market share in China, and specifically go into the low end of the market tier-three, tier-four cities, for paint that is at much lower price point than say [UK brand] Dulux… of course during 2017 raw materials prices went up significantly,” he said.
“We [were] getting close to a zero variable margin proposition [in the fourth quarter of 2017] and if we’re not careful it goes negative, so we kept our pricing discipline,” he added. “In China, across the board it's a bit of a pause I would say.”
While the company is not looking to reduce its global footprint, it is focused on optimising internal processes at present, according to Vanlancker.
Growth in the paints and coatings sector tends to outperform the general economy, which can allow players to target volume growth to obscure weaknesses in the business, he added.
“I do believe that AkzoNobel, at least as much as anybody else, in the past tried covered to cover up some internal deficiencies with just going after more volume, and in the paints and coatings industry that's often relatively easy,” he said.
Prompted by an attempt to repel a takeover bid by PPG, the €10.1bn sale of its specialty chemicals business and pivot into a pure paints and coatings player has presented an opportunity for the company to simplify its operations, tightening supply chains and reducing IT systems from 38 to one.
AkzoNobel completed €110m of administrative savings in 2018 and is planning an additional €200m in supply chain integration savings by 2020 as part of its drive to reach its RoS target.
The company managed to increase return on sales in the second half of 2018 at a time when RoS for many peers was dropping, but it still needs to increase that by 4.4 percentage points over the next two years to accomplish the target.
15 for 20 guidance issued last year (source: AkzoNobel)
“You could split the 4.4 percentage point growth into two parts, the margin part driven by pricing initiatives and the cost saving part,” said CFO Maarten de Vries.
Analyst Bernstein, which noted last year that the 15% RoS target was “achievable… [but] very demanding”, but was more optimistic this week after Akzo unveiled its fourth-quarter results.
“Every earnings call and appearance by the company reinforces the centrality of "15 by 20" to management – and their compensation is tied to it. We think it's achievable,” Bernstein said in an investor note.
The firm projected €1.5bn in earnings before interest and taxes (EBIT) for the company by 2020 and RoS of 14.6%, compared to €798m in 2018.
Although €6.5bn of the €7.5bn specialties sale proceeds is being returned to shareholders, the divestment fuelled speculation that the company would likely pursue a transformational merger or acquisition deal, to expand its reach and make it less of a target for other acquirers.
The company repelled PPG’s takeover bid and was linked to US player Axalta, but neither of those were conversations company management initiated, Vanlancker said.
“It was PPG who came after us and I think we couldn't have been more clear that the answer was no. It was also Axalta that initiated the conversation… and we looked at it and came to the conclusion no, because there was always a valuation point to do it,” he said.
While the company has not ruled out a big ticket M&A deal, the focus is currently on the 2020 RoS target, and the logistics of large-scale mergers could interfere with that process and be unlikely to generate any additional returns by that deadline.
“That doesn't mean that there couldn't be any value in a combination, but it is not necessarily a must. For us it is really on 15 by 20 to be focused and big transformational deal would frankly fall outside the scope of 2020 by the time you can actually consume the deal,” Vanlancker said.
“The bottom line is that the focus is on 15 by 20 and bolt-on acquisitions are really value generating towards realising those goals,” added de Vries.
However, any miss in projected earnings could reignite shareholder pressure for the company to pursue a deal, according to Credit Suisse.
PPG’s approach was backed by several significant AkzoNobel shareholders, who claimed that management was not sufficiently focused on returns.
While raw materials costs are expected to moderate through the first half of the year and may even turn positive later in the year, general economic growth expectations continue to sour, with each fresh economic model bringing a fresh downgrade to prospects for the eurozone.
“If the whole geopolitical macroeconomic situation, hyperinflation in Latin America and Turkey, Brexit, China trade, if these things settled down then you will see a propeller behind the business,” Vanlancker said.
“Self-help is what we do… but if we could have a little less of the headwinds, that obviously that would make life much easier,” he added.
Interview article by Tom Brown